Question

Kendra Brown is analyzing the capital requirements for Reynold Corporation for next year. Kendra forecasts that Reynold will need $12 million to fund all of its positive-NPV projects and her job is to determine how to raise the money. Reynold's net income is $9 million, and it has paid a $4 dividend per share (DPS) for the past several years (1 million shares of common stock are outstanding); its shareholders expect the dividend to remain constant for the next several years. The company's target capital structure is 30% debt and 70% equity.

1. Suppose Reynold follows the residual model and makes all distributions as dividends. How much retained earnings will it need to fund its capital budget? Enter your answer in dollars. For example, an answer of $2 million should be entered as 2,000,000, not 2. Round your answer to the nearest dollar.

   $  

2. If Reynold follows the residual model with all distributions in the form of dividends, what will be its dividend per share? Round your answer to the nearest cent.

   $  

   What will be its payout ratio for the upcoming year? Round your answer to two decimal places.

     %

3. If Reynold maintains its current $4 DPS for next year, how much retained earnings will be available for the firm's capital budget? Enter your answer in dollars. For example, an answer of $2 million should be entered as 2,000,000, not 2. Round your answer to the nearest dollar.

   $  

4. Can Reynold maintain its current capital structure, maintain its current dividend per share, and maintain a $12 million capital budget without having to raise new common stock?

   -Select-NoYesItem 5

5. Suppose management is firmly opposed to cutting the dividend; that is, it wishes to maintain the $4 dividend for the next year. Suppose also that the company is committed to funding all profitable projects and is willing to issue more debt (along with the available retained earnings) to help finance the company's capital budget. Assume the resulting change in capital structure has a minimal impact on the company's composite cost of capital, so that the capital budget remains at $12 million. What portion of this year's capital budget would have to be financed with debt? Round your answer to two decimal places.

     %

6. Suppose once again that management wants to maintain the $4 DPS. In addition, the company wants to maintain its target capital structure (30% debt, 70% equity) and its $12 million capital budget. What is the minimum dollar amount of new common stock the company would have to issue in order to meet all of its objectives? Enter your answer in dollars. For example, an answer of $2 million should be entered as 2,000,000, not 2. Round your answer to the nearest dollar.

   $  

7. Now consider the case in which management wants to maintain the $4 DPS and its target capital structure but also wants to avoid issuing new common stock. The company is willing to cut its capital budget in order to meet its other objectives. Assuming the company's projects are divisible, what will be the company's capital budget for the next year? Enter your answer in dollars. For example, an answer of $2 million should be entered as 2,000,000, not 2. Round your answer to the nearest dollar.

   $  

8. If a firm follows the residual distribution policy, what actions can it take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?

       -Select-Increase its capital budget.Increase dividends.Declare a stock dividend.Issue new common stock.Change capital structure, that is, use less debt.Item 9

Answer 1

(a)

Here

Amount needed to fund all of its positive-NPV projects = $12 million

Equity in company's target capital structure = 70% = 0.7

Debt in company's target capital structure = 30% = 0.3

So, if the firm follow a residual model and pay dividends after retaining funds for the capital budget, then:

Amount to retain for the capital budget = Amount needed to fund all of its positive-NPV projects * Equity in company's target capital structure

     = $12 million * 0.70

     = $8.4 million

The amount of retained earnings it will need to fund its capital budget = $8.4 million = $8,400,000

(b)    

Number of shares of common stock are outstanding = 1 million

Net income = $9 million

Dividends per Share (DPS) = (Net income - Amount of retained earnings)

= ($9 million – $8.4 million ) / 1 million shares

= $0.6 million / 1 million

= $0.60

Dividends paid = Dividends per Share * Number of shares of common stock are outstanding

                          = $0.60 * 1 million

                          = $0.60 million

Payout ratio for the upcoming year = Dividends paid / Net income

            = $0.60 million / 9 million

             = 0.06666

             = 6.67%

(c)     

Dividends per Share (DPS) = $4

Dividends paid = Dividends per Share * Number of shares of common stock are outstanding

                          = $4 * 1 million

                          = $4 million

Net income = $9 million

Retained earnings for the firm's capital budget = Net income - Dividends paid

= $9 million - $4 million

= $5 million

= $5,000,000

(d)

No, the firm cannot maintain its current capital structure, maintain its DPS and maintain a $12 million capital budget without raising new stock. Since the firm maintain the capital budget and maintain the capital structure Debt-Equity ratio, the needed retained earnings is equal to $8.4 million, but at the current dividend per share policy the maximum retained earnings are $5 million. That is, with the current DPS policy the retained earnings are less than the equity amount required to be retained in order to fund the capital budget will maintaining the current capital structure